Anup Srivastava and his colleagues discover a surprising link between executive compensation packages and firms that fall short on earnings targets

By Beverly A. Caley

When managers are compensated with stock options, their interests become aligned with those of shareholders — at least according to conventional wisdom. But a new study shows that some CEOs purposely miss earnings targets, causing a drop in stock prices just before stock options are granted — an outcome that is clearly inconsistent with shareholders' interests.

Generally accepted accounting principles allow managers to use broad discretion when reporting earnings. That is because it is impossible to create rules that anticipate all possible situations, explains Anup Srivastava, an assistant professor and Donald P. Jacobs Scholar in Accounting Information & Management. Managers exercise this discretion in deciding when and what to report, and it is expected that they will provide information that is useful to investors.

However, the new research suggests that this discretion is sometimes abused and "highlights a situation where CEOs might trade off firm value to enhance personal wealth," Srivastava and his coauthors write in The Accounting Review.

Srivastava teamed with Texas A&M accounting professors Mary Lea McAnally and Connie D. Weaver to examine whether option grants can encourage executives to miss their earnings targets. They gathered CEO compensation data from 1992-2005 for 1,724 firms in a broad cross-section of industries, then compared quarterly and yearly data for fixed-date grants with firms' announcements that they had missed earnings targets.

The researchers found that firms that missed those goals had larger and more valuable subsequent grants. In addition, firms that set aside a portion of earnings to bolster future statements (a practice known as "managing earnings downward") saw an increased likelihood of missing targets with the granting of stock options.

"The behavior that we document could be irrational if it was repeated so often that the CEO might reasonably anticipate being caught and punished or if the CEO did not expect a stock-price rebound before he/she exercised options or sold stock," the researchers acknowledge.

Further analyses revealed that the probability that firms would miss their quarterly earnings targets just before the dates that the stock options were granted was abnormally higher than the firms' own time-series average. However, this difference was reversed in the quarter following those grant dates. Moreover, immediately following those grant dates, the probability of beating earnings targets increased significantly.

These findings cannot be explained by the backdating of grant dates, Srivastava says, because the researchers used only fixed-date grants, which occur on roughly the same date each year. They also controlled for factors such as CEO stock option exercises, CEO performance-linked bonuses and firm proximity to default on debt covenants, all of which lower the probability of missing earnings targets. Taken together, the authors conclude, these results show that missing an earnings target can be a rational executive decision.

The authors do not equate "rational" with "legitimate," of course. "Missing an earnings target is particularly egregious because stock prices are likely to tumble — an outcome clearly inconsistent with shareholders' interests," they note. The bottom line, Srivastava says, is that "compensation committees and shareholders need to be vigilant in observing the relationship between missed earnings targets and stock option grants."